What is the Real Fiscal Responsibility? Higher Living Standards or Control of Fiscal (Deficit and Debt) Ratios?

 

The UK’s new fiscal policy launched in last week through the mini budget of the new government has shaken up the global community of monetary pandiths and central banks. The reason is the landmark cuts in tax rates and the cap on energy bills of households (or energy price guarantee). The new fiscal policy is known as growth plan for the UK economy.

The new Chancellor in his first day of the office sacked the Treasury Secretary, who was credited for tight control of spending, by claiming for the focus on growth not fiscal discipline.  Accordingly, new fiscal responsibility is to return to GDP growth of 2.5% and control of the soaring cost of living. All Ministries have been requested to be growth units in respective areas.

The UK is the global origin of the growth-focused fiscal policy school emerged on the philosophy of John Maynard Keynes, a renowned British Economist (1883-1946). Therefore, the present UK fiscal policy is no doubt driven by same school.

Therefore, the objective of this article is to throw some views on the need to revisit the fiscal responsibility in the national economic and public interest as against the current concept of the ratio-based fiscal discipline.

Current Version of the Fiscal Responsibility

With the emergence of the monetary school, money driven inflation phobia and state central banks with the independent monetary policy, the fiscal policy, i.e., public spending, tax and debt, also has been categorized as a part of the aggregate demand that drives the general price level and inflation through money.

As governments are big in economies, the government spending is the single biggest component in the aggregate demand that is politically determined outside the market forces. Therefore, monetarists have been advocating for the fiscal discipline or space so that the monetary policy is able to control inflation or maintain economic and price stability through the interest rate weapon affecting the private markets.

This has led to force the governments to control the budget deficit and debt as ratios to GDP at low levels such as deficit of 4.5% and debt below 80% or 100% which is the current version of the globally accepted fiscal responsibility. In some countries such as Sri Lanka, fiscal legislations also have been enacted to prescribe the future path of the fiscal ratios towards arbitrary targets to ensure the fiscal responsibility in that line.

Accordingly, this fiscal responsibility club has got a deep network across the world in numerous conduits.

• First, with open economic policies, as developing countries live in the global economy through borrowing from IMF, World Bank and international financial markets, these fiscal ratios have become number one item for country credit assessment by multinational financial institutions, investors and rating institutions where the IMF has now introduced a concept of debt sustainability to discipline these countries. 

In such assessments, government deficit and debt also are treated similar to those of private entities without any regard to their roles of macroeconomic and public welfare perspectives in democratic societies. Therefore, the global practice has been to slam the national budgets no sooner they are presented to the Parliament by just looking at the deficit and debt ratios.

• Second, central banks who claim that they have the divine power to control inflation at 2% or mid-single digits as they prefer and maintain price stability in the economy in the medium to long-term blame the fiscal indiscipline as the cause for inflation going beyond the targets.

• Third, the monetary school has got international spokesmen mostly retired Treasury and central bank officials around the world and their agents in high-ranking unelected public jobs in the Treasuries and central banks as well as in elected positions in the Parliaments. Meanwhile, central banks also stay critical on governments akin to those parties without performing their own mandates, other than making public speeches of technical jargon about price stability and inflation.

• Fourth, lower fiscal ratios are sold to attract foreign private investors to the local debt market and fund the foreign reserve for running the monetary policy largely free from the fiscal policy. This has paved the way for globally active geopolitical groups to intervene in governments through private capital flows that are highly volatile.

• Fifth, financial market dealers who hang around central banks are the conduit that disrupts fiscal stimulus proposals even before they are implemented by abruptly raising interest rates and depreciating the currency for speculative profit. This is due to the thinking sowed by central banks and monetarists that fiscal spending and accompanying debt would raise the demand for credit and foreign currency through the increased aggregate demand which would raise interest rates and exchange rates. Therefore, governments are compelled to rollback new fiscal proposals to calm the money markets and fiscal policy critics.

Therefore, the hands of the elected government are so tied that fiscal policy has virtually become the point of the failure of any government from its inception, despite the public powers on spending, taxing and money creation available with governments.

UK’s New Fiscal Policy Responsibility and World Response

The fiscal policy is the weaponry available to elected governments to fulfil election promises made to the public in democratic system. Therefore, the new UK government has proposed a growth plan to ease the four decades high inflationary pressures and recession already touched down in the UK. This is the current macroeconomic environment spreading across the globe.

The soaring inflation is mainly due to supply side problems arising from supply chain bottlenecks attributable to both Corona pandemic of two years (2020 nd 2021) and Ukraine war since February, this year. However, central banks globally have rallied to raise interest rates at historic levels to control inflation which is causing further inflationary pressures through the increased cost of production, economic slowdowns and recession globally.

As there are no signs that the Bank of England could correct the situation in the near-term, the new government has started firing its fiscal weapons while alarming the Bank of England to deliver its inflation control job without blaming the Ukraine war.

Tax cuts are the conventional fiscal stimulus strategy to promote the growth and employment during difficult times. As private spending will be more efficient in promoting the growth during periods of high interest rates, tax cuts are preferred to increased government spending through tax hikes. As the government is able to fund the public services inclusive of energy subsidy though debt, the tax cuts provide non-debt saving of resources to the private sector. Therefore, this fiscal stimulus strategy would be non-inflationary, especially when the monetary policy is on fast-track to control inflation.

However, news shows that the whole world of monetary networks on fiscal discipline has joined hands in protest for the UK's  new fiscal policy just within a week.

• First, former US Treasury Secretary Larry Summers commented on 25^th September that the UK government behaves like an emerging market government and the Sterling Pound would fall below the US Dollar.

• Second, UK financial market panicked on Monday and Tuesday (26^th and 27^th) with record increases in interest rates and the currency depreciation. For example, UK 10-year Treasuries rose by 1.17% from 3.32% on September 21 to 4.49% on September 27 and the Pound fell by 8.8% from US$ 1.17 on September 12 to US$ 1.06 on September 28, first time since 1985. Accordingly, markets started repricing financial products with the expectation of the Bank Rate hike by 150-200 basis points in November.

• Third, the media led by the opposition criticized that tax cuts would benefit the richest 1% and make the next generation worse off. According to some critics, the richest 10% of households would gain the most.

• Fourth, the Bank of England Governor released a statement on 26^th September with twisted words that the Bank is monitoring developments in financial markets very closely in light of the significant repricing of financial assets and welcomes the role of the Office for Budget Responsibility in its assessment of prospects for the economy and public finances (including of independent forecasts of the impact of government's plans on the economy).

It further stated that the Monetary Policy Committee would make a full assessment of the impact on demand and inflation from the Government’s fiscal announcements and the fall in sterling and would not hesitate to change interest rates by as much as needed to return inflation to the 2% target sustainably in the medium term, in line with its remit. This is an unnecessary statement as the Bank's mandate is independent.

However, the Bank today had intervention in long-dated govt. Bonds to prevent the extent of the rise in yield rates to restore orderly functioning market conditions, for example, 10-year bond yield fell back to 4.06% on September 28 (as compared to 4.49% on September 27) and has pledged unlimited long-dated bond buying until 14 October as the necessity arises while suspending of bond selling until 31 October. This is in line with the Bank's mandate.

• Fifth, the IMF has expressed adverse comments on the mini budget with a request to reevaluate the tax cuts and energy subsidy in the light of fiscal discipline. This is an unwarrented statement as the UK does not request IMF assistance.

• Sixth, media reported that the Prime Minister was going to issue a statement to calm the markets, but later reported that the Prime Minister agreed the Treasury would issue a statement promising further details on 23 November on how the government would ensure borrowing would not spiral out of control.

As such, forces surrounding the fiscal discipline-based responsibility are active to push the government for fiscal brakes or U turn.

What should be the real fiscal responsibility?

Governments are elected on promises to promote socio-economic welfare of the general public whereas the national budget or public finance is the key weapon available to fulfil such promises at targets. 

Therefore, the fiscal responsibility and discipline should be redefined to cover targets of the living standards of the general public. For example, targeting a fiscal balance by rising taxes and cutting the public services has no meaning for Sri Lanka struggling in bankruptcy and poverty.

Practically, national budget is the driver of the economy on both real side and financial side.

• First, public services including infrastructure determine the economy’s production capacity and productivity.

• Second, debt provides for a low-risk financial portfolio for money creation and private wealth management.

• Third, the national budget has instruments for redistribution of wealth and income to ensure fair distribution of resources and living standards.

• Fourth, it is the fiscal responsibility to bailout private market failures in the national interest.

• Fifth, the maintenance of a strong regulatory systems to promote fair markets requires significant fiscal spending.

• Sixth, although restricted fiscal ratios are expected to promote the private sector and markets, they cannot emerge without government’s fiscal support due to heavy government regulations enforced on markets such as money and foreign exchange markets and labour markets. Further, private markets which operate on financial profit motive cannot be expected to takeover the socio-economic role played by the public finance.

• Seventh, fiscal ratios have no meaning on real resources and living standards behind those them while such ratios are the results of numbers or estimates with a lot of issues.

• Eighth, there is no consistency of fiscal ratios across the countries to set benchmarks and, therefore, ratios are highly arbitrary and biased against developing countries on account of debt sustainability.

All these must be considered in determining the living standards of the public and the country’s global rating. Therefore, fiscal responsibility determined in line with standard fiscal ratios is socially and economically detrimental to emerging nations. 

This is the reason why the new UK government follows a growth plan rather than the standard fiscal discipline to rescue the UK economy from supply chain bottlenecks, soaring inflation and looming recession in the national interest.

Therefore, it is proposed that the fiscal responsibility in Sri Lanka too be redefined in terms of targets of living standards and sectoral production levels by scraping the fiscal ratio benchmarks, given the urgent need to recover the economy and general public from the present economic and financial crisis that has been caused by same fiscal ratios-based macroeconomic management model. This is the thinking behind the Modern Monetary Theory.

Otherwise, the continued adherence to the IMF-based fiscal discipline with further restricted fiscal ratios and conditionalities combined with extra-tight monetary policy with interest rates above 30% would not only deprive the Parliament of its national monetary and fiscal autonomy and control as set out in the Constitution but also push the economy and the public into deeper bankruptcy and poverty in the present circumstances.

This is not acceptable as the fiscal policy and monetary policy are not meant to fund only the government’s mere existence as determined by few unelected officials in the Treasury and Central Bank in line with the thoughts of the international monetary school. Both policies in democratic societies are meant to promote living standards of the public by creating real and financial resources parallelly in adequate amounts.

In that perspective, I am at a loss to understand why the government allows few public officials to run the fiscal policy and monetary policy in the current form of numbers-based responsibilities while the general public continues to struggle in the bankruptcy and poverty.

 (This article is released in the interest of participating in the professional dialogue to find out solutions to present economic crisis confronted by the general public consequent to the global Corona pandemic, subsequent economic disruptions and shocks both local and global and policy failures.)

 

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 10 Economics and Banking Books and a large number of articles published)